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If you're paying taxes and planning for your retirement, understanding Social Security is essential. You've likely come across it in discussions, especially when politicians debate how to fix it. But what's the root of the problem, and what exactly is this system? We have all the answers you need right here.
What Exactly Is Social Security?
In the United States, Social Security provides government assistance to three key groups: retirees, families of disabled or deceased workers, and individuals with disabilities.
When you receive a paycheck, you may notice a portion being deducted for something called FICA. This stands for the Federal Insurance Contributions Act tax, and it helps fund Social Security. Your contributions go into a fund, from which current Social Security recipients (perhaps your grandparents?) are paid. When it’s your turn to retire, you’ll be drawing from that same fund, supported by future generations paying taxes (maybe even your grandchildren!).
This fund consists of two main trust funds: the Old-Age and Survivors Insurance (OASI) fund and the Disability Insurance (DI) trust fund. When the incoming funds exceed the amount needed for payouts, the Social Security Administration (SSA) has a surplus. This surplus earns interest, just as you might earn interest if you saved extra money in a bank. The government can also use this surplus, much like a bank might lend out your savings.
What Happens When You Become Eligible
As you enter your 60s, thoughts of retirement will likely cross your mind. This means applying for Social Security to help fund your retirement. Ideally, though, Social Security shouldn't be your only source of income. Over the years, you should have saved for retirement—perhaps through an employer-sponsored 401(k) or an Individual Retirement Account (IRA), or even a pension.
Social Security can certainly help supplement your retirement income. The maximum monthly benefit is $2,663, which isn’t much, and many people will receive less than that. The amount you're eligible to receive depends on several factors, including your work history and earnings.
Your age: You can begin receiving Social Security as early as 62, but your “full retirement age” is 65 (or older—you can check your specific retirement age here). If you retire earlier than this, your monthly benefits may be reduced by up to 25% for the rest of your life. This is because you're accessing the funds sooner, so the same amount is spread out over a longer period. On the other hand, if you retire after reaching your full retirement age, you could receive an 8 percent increase each year until you reach 70.
Your earnings history: The Social Security Administration (SSA) takes the 35 years when you earned the highest income to calculate your Average Indexed Monthly Earnings (AIME). They then apply a formula based on this number to determine your benefit amount.
Government work: If you worked for the government and received a pension, the SSA uses a different formula to calculate your benefits.
The SSA offers a helpful calculator to estimate your retirement benefits. You can also access a future earnings estimate by signing up at the My Social Security website.
Below are the average monthly Social Security benefits as of July 2015, according to the SSA:
$1,336/month for retired workers;
$1,282/month for widows or widowers over age 60;
$1,165/month for workers with disabilities;
$1,979/month for a disabled worker, their spouse, and one or more young children;
$2,631/month for a widowed mother and her two children.
If you're ready to start receiving benefits—whether for retirement, disability, or survivor’s benefits—you can initiate the process by calling the SSA, visiting an office, or applying online. The SSA provides clear instructions here.
The True Issue with Social Security
You’ve likely heard that Social Security is doomed, and that we’ll completely run out of Social Security funds within the next few decades, leaving you without benefits. This is actually false. However, it doesn't mean everything is perfect either.
Another common myth is that the government is continuously borrowing from the Social Security fund, causing it to run out. That’s not the issue either.
The real problem is straightforward: we’re paying out more from Social Security than we’re taking in.
Social Security, in theory, is a brilliant idea: you pay taxes now to secure your retirement later. The issue is that it doesn’t work as smoothly in practice because the money you contribute goes to an entirely different generation—it doesn’t come straight back to you. With the Baby Boomer generation retiring, we now have a large number of retirees, resulting in higher payouts. Meanwhile, there are fewer workers paying into Social Security. So, we’re receiving less money than we’re giving out: Investopedia refers to this as a declining “worker-to-beneficiary” ratio. It's not an immediate crisis, because we have a surplus, but that surplus is dwindling.
When you hear about Social Security funds being “depleted,” it doesn’t mean Social Security itself is collapsing or that disaster is imminent. It simply means we’ll run out of the surplus funds—think of it as the money in the piggy bank. People are still paying Social Security taxes, so money is still coming in. However, it's not enough, and if we continue on this path, future generations won’t receive as much.
For instance, the Disability Insurance trust fund is expected to be exhausted by next year. According to the SSA:
The Trustees still project that the Social Security Disability Insurance (DI) Trust Fund will be depleted by late 2016 if lawmakers don’t intervene. This looming shortfall in DI funding threatens beneficiaries with sudden and significant cuts to their benefits, marking the beginning of broader financial imbalances within both Social Security and Medicare.
Once the fund runs dry, incoming taxes will only cover about 81% of those set to receive benefits. Since it’s not feasible to just leave out a portion of beneficiaries, the SSA will have to reduce everyone’s disability payments by 19% to solve the problem.
And this is just regarding disability benefits. The remainder of Social Security’s trust fund is predicted to run out by 2034. While that won’t mean benefits will stop entirely, it will result in reduced payments for everyone. If the current trajectory continues, we can expect cuts of around 20%, according to the Motley Fool:
If Congress fails to find a long-term solution involving increased revenue and/or reduced spending, eligible beneficiaries will face a 23% reduction in their benefits. This is a serious issue, causing concern among seniors and those nearing retirement.
Considering that most retirees rely on Social Security for half or more of their income, a 20% cut would be a significant blow to their financial security.
What the Government Is Doing About It
Politicians have various proposals for addressing the Social Security crisis, but most come down to either raising taxes or cutting benefits. You can check out OnTheIssues to see where each politician stands, but in general, their ideas fall into one of these two categories.
Currently, there’s a limit to how much Social Security tax taxpayers have to pay. In 2015, the maximum taxable income was $118,500, meaning that if you earn more than that, you’re only taxed on the first $118,500. Many politicians have suggested raising this threshold, but The Commission to Modernize Social Security proposes eliminating the cap entirely. Member Maya Rockeymoore told Bankrate that while wages have been relatively stagnant for most workers in recent years, the income of the top 2% of earners has soared. By removing the cap, high-income earners would pay more into Social Security.
Alternatively, we could increase the retirement age. While this would still reduce the full benefit amount since retirement would be delayed, it wouldn't require raising taxes. The retirement age for future generations is already set to rise to 67 by 2027. The Business Roundtable suggests raising it even further to 70.
How to Ensure You Have Enough to Retire
You’ll still receive some Social Security benefits, but whether that’s sufficient to cover your retirement needs is another question entirely. Currently, benefits average around $1,300 a month, so even if that amount stays the same, it’s unlikely you’ll be living luxuriously in Paris solely on Social Security checks.
The best approach is to secure your own retirement through personal savings. It’s easier said than done, but it’s far more dependable than relying on politicians to resolve the issue. The earlier you start saving, and the more you save, the better off you’ll be. To get started, consider doing the following:
Make sure to take full advantage of your employer’s 401(k) match
Look into opening an IRA
Learn how to create a simple “set and forget” investment portfolio
In short, while things aren’t as dire as they may seem, and Social Security won’t disappear entirely when younger generations retire, we might not receive as much as expected. It’s helpful to understand the current situation, how it’s being addressed, and, in the meantime, take steps to strengthen your personal savings.
Photo credit: Tara Jacoby.
